Accounting and finance for lawyers in a nutshell, 5 edition

WEST’S LAW SCHOOL
ADVISORY BOARD
__________
JESSE H. CHOPER
Professor of Law and Dean Emeritus,
University of California, Berkeley
JOSHUA DRESSLER
Professor of Law, Michael E. Moritz College of Law,
The Ohio State University
YALE KAMISAR
Professor of Law Emeritus, University of San Diego
Professor of Law Emeritus, University of Michigan
MARY KAY KANE
Professor of Law, Chancellor and Dean Emeritus,
University of California,
Hastings College of the Law
LARRY D. KRAMER
President, William and Flora Hewlett Foundation
JONATHAN R. MACEY
Professor of Law, Yale Law School
ARTHUR R. MILLER
University Professor, New York University
Formerly Bruce Bromley Professor of Law, Harvard University
GRANT S. NELSON
Professor of Law, Pepperdine University
Professor of Law Emeritus, University of California, Los Angeles
A. BENJAMIN SPENCER
Professor of Law,
Washington & Lee University School of Law
JAMES J. WHITE

Professor of Law, University of Michigan


I

ACCOUNTING AND FINANCE FOR LAWYERS
IN A NUTSHELL
FIFTH EDITION
By
CHARLES H. MEYER
Senior Vice President
Taxes and Senior Tax Counsel
GE Capital Aviation Services

Mat #41337719


II
Thomson Reuters created this publication to provide you with accurate and authoritative
information concerning the subject matter covered. However, this publication was not
necessarily prepared by persons licensed to practice law in a particular jurisdiction.
Thomson Reuters does not render legal or other professional advice, and this publication
is not a substitute for the advice of an attorney. If you require legal or other expert
advice, you should seek the services of a competent attorney or other professional.
Nutshell Series, In a Nutshell and the Nutshell Logo are trademarks registered in the U.S.
Patent and Trademark Office.
COPYRIGHT © 1995 WEST PUBLISHING CO.
West, a Thomson business, 2002, 2006
© 2009 Thomson Reuters
© 2013 Thomson Reuters

610 Opperman Drive
St. Paul, MN 55123
1-800-313-9378
Printed in the United States of America
ISBN: 978–0–314–28564–5


III
To
Joseph and Lisa Meyer


V

FOREWORD TO THE FIFTH EDITION
__________
The accounting world and accounting rules continue to change reflecting both changes
in the business environment and refined thinking about how transactions and events
should be presented in financial statements. The fifth edition reflects the key
developments that have occurred since the fourth edition.
As in the case of both the third and fourth editions, the FASB adopted further changes
to the rules regarding transfers of receivables and servicing rights and obligations, which
continues to be a hot topic. Chapter 5 has been updated to reflect these further changes.
Changes to the rules for the consolidation of “variable interest entities” were duscussed
in the fourth edition. Since then, the FASB has continued to refine these rules.
Since the rules regarding goodwill created in connection with business acquisitions were
amended to require an annual quantitiative impairment review for goodwill rather than
an automatic amortization of goodwill, companies have been concerned about the time
and cost involved in performing these impairment reviews. As discussed in Chapter 8, the
FASB has introduced a new concept for testing goodwill.

VI
A company now first undertakes a “qualitative” assessment to determine if it is more
likely than not that an impairment of goodwill has occurred. If that is not the case, it is
not necessary to undertake the quantitative testing of goodwill for impairment.
The requirement to present total “comprehensive income” in addition to the traditional
net income continues to receive focus by the FASB. The FASB adopted new standards
allowing companies to elect between preparing one continuous statement that presents
both net income and comrephensive income or preparing two statements, one for net
income and one immediately following that presents other comprehensive income and
comes to a total that includes all the components of comprehensive income.
Aside from these substantive changes, one of the biggest developments in accounting
in the United States was the issuance by the FASB of a codification of accounting
standards that came out while the fourth edition was in production. The individual FASB
statements and interpretations and other sources of official accounting guidance in the
United States have been incorporated into a consolidated set of accounting rules. The
FASB now periodically issues accounting standards updates that amend the codification.
The fifth edition has been revised to reflect the new citations to the codification. There is
also a cross reference table in the appendix that cross references between the old FASB
(and APB) pronouncement
VII


numbers that were covered prominently in prior editions and the new codification
references.
As always, I trust that this fifth edition will continue to provide law students, lawyers,
and other readers with a sufficient understanding of the basics of accounting and finance
so that they can better appreciate the significance of accounting and its importance in the
commercial and legal world.
CHM
Norwalk, CT

October 2012


XXIII

ACCOUNTING AND FINANCE FOR LAWYERS
FIFTH EDITION


IX

OUTLINE
__________
FOREWORD TO THE FIFTH EDITION
Chapter 1. The Basic Financial Statements
A. The Balance Sheet
1. Assets
2. Liabilities
3. Owners’ Equity
4. The Balance Sheet Equation
5. Balance Sheet Format
B. The Income Statement
1. Revenues and Gains
2. Expenses and Losses
3. Format of the Income Statement
C. The Statement of Owners’ Equity
D. Statement of Cash Flows
E. Additional Information
1. Footnotes
2. Supplemental Disclosures

3. Management’s Discussion and Analysis
4. Audit Report
Chapter 2. The Accounting Process
A. Source Documents
B. Journal Entries
C. Ledgers and Posting
D. Adjusting Entries
1. Accrued Revenues and Expenses
a. Accrued Revenues
b. Accrued Expenses
X
c. Accounting for Actual Receipt of Payment
d. Reversing Entries
2. Deferred Revenues and Expenses
a. Deferred Revenues


b. Prepaid Expenses
3. Depreciation Expense
4. Recognizing Cost of Goods Sold
E. Revenue and Expense Accounts
F. Closing the Books
G. Preparation of Financial Statements
Chapter 3. Generally Accepted Accounting Principles
A. Sources of GAAP
1. Pre-Codification Official Pronouncements of the FASB and Its Predecessors
a. FASB Statements and Interpretations
b. APB Opinions
c. Accounting Research Bulletins
d. Enforcement of Official Standards

2. Other Sources of GAAP
B. Governmental Regulation of Accounting
1. SEC
2. Regulatory Agencies
C. Income Tax Accounting
D. Some Fundamental Accounting Concepts
1. Historical Cost
2. Measuring Fair Value
3. The Going Concern Assumption
4. Yearly Reporting
5. Revenue Recognition and Matching
6. Conservatism
XI
7. Materiality and Cost–Benefit Analysis
Chapter 4. Recognition of Revenues and Expenses
A. Revenue Recognition
1. Sale of Goods or Services
2. Revenue From Services
a. Specific Performance Method
b. Proportional Performance Method
c. Completed Performance Method
3. Long Term Contracts
4. Revenue Recognized With the Passage of Time
5. Revenue Recognized Based on Receipt of Cash
6. Completion of Production


7. Changes in Market Value
8. Asset Writedowns
B. Matching

1. Direct Matching
2. Immediate Write–Off
3. Systematic and Rational Allocation
Chapter 5. Current Assets and Liabilities
A. Cash
1. Cash Equivalents
2. Restricted Cash
3. Petty Cash
4. Internal Controls
B. Marketable Securities
C. Receivables
1. Trade Receivables
2. Other Receivables
3. Reporting Receivables
4. Bad Debts
XII

D.
E.

F.

G.
H.
I.
J.

a. Percentage of Sales Method
b. Aged Receivables Analysis
5. Financing and Sales of Receivables

6. Notes Receivable
7. Imputing Interest
8. Receivables From Related Parties
Prepayments
Accounts Payable
1. Reporting Accounts Payable
2. Imputing Interest
Short Term Borrowings
1. Interest on Notes Payable
2. Currently Maturing Amounts of Long Term Debt
Accrued Liabilities
Deferred Revenues and Deposits
Estimated Liabilities
Contingent Liabilities

Chapter 6. Accounting for Inventories
A. Determining Physical Quantities on Hand


1. Periodic Inventory System
2. The Perpetual Inventory System
B. Determining Inventory Values
1. Specific Identification
2. Cost Flow Assumptions
a. First In, First Out Method
b. Last In, First Out
c. Average Cost
d. Application to Perpetual Inventory Systems
e. Retail Inventory Methods
C. Applying Lower of Cost or Market

1. Determining Market
XIII
2. Effect on Inventory and Cost of Goods Sold
D. Manufacturing Companies
Chapter 7. Property, Plant, and Equipment and Depreciation
A. Accounting at Acquisition
1. General Rule
2. Exchanges for Other Property
3. Acquisitions of Multiple Assets
4. Self–Constructed Assets
B. Accounting for Depreciation
1. Useful Life
2. Salvage Value
3. Method of Depreciation
a. Straight Line Method
b. Sum-of-the-Years’-Digits Method
c. Declining Balance Method
d. Units of Production Method
e. Depletion of Natural Resources
f. Other Methods
C. Repairs and Improvements
D. Disposal of Fixed Assets
E. Impairment of Fixed Assets
Chapter 8. Intangible Assets
A. Identifiable Intangible Assets
1. Types of Identifiable Intangible Assets
a. Patents


b.

c.
d.
e.

Copyright
Trademarks, Service Marks, and Trade Names
Franchises
Deferred Charges
XIV

2. Accounting for the Purchase of Identifiable Intangible Assets
3. Initial Accounting for Internally Created Identifiable Intangible Assets
a. Research and Development
b. Computer Software Costs
4. Accounting for Identifiable Intangible Assets After Acquisition
B. Goodwill
Chapter 9. Accounting for Investments
A. Investments in Bonds
1. Acquisition of Bonds at Face Value
2. Acquisition of Bonds at a Discount or Premium
a. Straight Line Amortization of Bond Discount or Premium
b. Effective Interest Method of Amortizing Bond Discount and Premium
3. Changes in Value After Acquisition
4. Impairments of Loans
B. Accounting for Stock Investments
1. The Cost Method
a. Dividend Income
b. Changes in Value After Acquisition
c. Stock Splits and Stock Dividends
2. The Equity Method

3. Consolidated Financial Statements
4. Consolidation of Variable Interest Entities
C. Derivatives and Other Financial Instruments
1. Definition of Derivatives
2. Accounting for Derivatives
XV
a. Fair Value Hedges
b. Cash Flow Hedges
c. Foreign Currency Hedges
D. Other Investments
1. Land
2. Cash Value of Life Insurance


3. Sinking Funds and Other Permanent Funds
Chapter 10. Accounting for Long Term Debt
A. Forms of Long Term Debt
B. Accounting for Long Term Debt Issued at Par Value
1. Issuance on an Interest Payment Date
2. Issuance of Bonds Between Interest Payment Dates
C. Accounting for the Issuance of Bonds at Other Than Par Value
1. Bonds Issued at a Discount
2. Bonds Issued at a Premium
D. Bond Issuance Costs
E. Retirement of Bonds Prior to Maturity
1. Actual Retirements
2. In–Substance Defeasance
F. Restructuring of Long Term Debt
1. Restructuring With No Gain or Loss
2. Restructuring With Recognition of Gain

G. Convertible Debt
1. Conversion—Book Value Method
2. Conversion—Market Value Method
3. Induced Conversions
4. Debt Issued With Stock Warrants
H. Stock Treated as Debt
1. Mandatorily Redeemable Stock
XVI
2. Obligations to Repurchase Shares
3. Certain Obligations to Issue Shares in the Future
Chapter 11. Accounting for Leases
A. Introduction
B. Characterizing and Accounting for Leases
1. Accounting by the Lessee
2. Accounting by the Lessor
3. Changes in the Terms of a Lease Originally Treated as a Capital Lease
C. Special Rules
1. Leveraged Leases
2. Leases Involving Real Estate
3. Sale/Leasebacks
D. Disclosures Regarding Leases


Chapter 12. Accounting for Other Long Term Liabilities
A. Accounting for Income Taxes
1. Temporary Differences
a. Types of Temporary Differences
b. Deferred Tax Liabilities
c. Deferred Tax Assets
d. Analysis of Deferred Taxes

e. Multiple Period Effects
2. Net Operating Losses
3. Valuation Allowances on Deferred Tax Assets
4. Reporting Deferred Tax Liabilities and Assets in the Balance Sheet
5. Intraperiod Tax Allocation
6. Permanent Tax Differences
B. Accounting for Retirement Plans
XVII
1. Defined Contribution Plans
2. Defined Benefit Plans
a. Components of Pension Expense
(i) Current Service Cost
(ii) Interest Cost
(iii) Amortization of Transition Cost
(iv) Prior Service Cost
(v) Actuarial Gains and Losses
(vi) Expected Return on Plan Assets
b. Pension Assets and Liabilities
c. Under- or Over-Funded Status
d. Disclosures
C. Accounting for Other Post–Retirement Benefits
Chapter 13. Accounting for Stock and Stockholders’ Equity
A. Contributions to Capital
1. Contributed Capital Accounts
2. Issuing Stock for Cash
3. Issuing Stock for Noncash Property
4. Stock Subscriptions
5. Stock Issuance Costs
6. Disclosures About Capital Structure
B. Accounting for Retained Earnings

C. Accounting for Dividends and Other Distributions


1. Key Dates Related to Dividends
2. Cash Dividends
3. Property Dividends
4. Stock Dividends
5. Distributions of Stock Rights
6. Stock Splits
D. Other Adjustments to Retained Earnings
1. Prior Period Adjustments
XVIII

E.

F.
G.

H.

2. Appropriations
Accounting for Treasury Stock
1. The Cost Method
2. The Par Value Method
Convertible Stock
Stock Options and Stock Appreciation Rights
1. Stock Options
2. Stock Appreciation Rights
3. Disclosures
Other Comprehensive Income

Chapter 14. Partnership Accounting
A. Capital Accounts
B. Defining a Partner’s Interest in Profits and Losses
1. Allocating Individual Items of Income or Loss
2. Recognizing Different Forms of Partner Contributions
a. Allocation for Services
b. Return on Capital
c. Residual Income and Loss Sharing Ratios
C. Admission of New Partners
1. Transfer of Partnership Interests
a. No Adjustments to Partnership Net Assets
b. Adjusting Partnership Net Assets
2. Contribution to the Partnership
a. No Adjustment to Partnership Capital Accounts
b. The Goodwill Method
c. The Bonus Method
XIX
D.

Retirement of Partners


1. Goodwill Method
2. Bonus Method
Chapter 15. Accounting for Business Combinations
A. Acquisition Method of Accounting
1. Recording the Acquisition
2. Effects of the Acquisition Method on the Income Statement
3. Accounting for Acquisition Costs

4. Recording Adjustments in Stock Acquisitions
Chapter 16. Earnings Per Share and Financial Ratios
A. Earnings Per Share
1. Basic Earnings Per Share
2. Diluted EPS
a. Effect of Stock Options
b. Effect of Convertible Securities
B. Financial Ratios
1. Measures of Liquidity
a. Current Ratio
b. Quick Ratio
2. Measures of Leverage
a. Debt–Equity Ratio
b. Debt to Asset Ratio
c. Times Interest Earned
d. Times Fixed Charges Earned
3. Activity Ratios
a. Asset Turnover
b. Receivables Turnover
c. Inventory Turnover
4. Measures of Profitability
XX
a.
b.
c.
d.
e.
f.
g.

Profit Margin
Return on Assets
Return on Equity
Earnings Per Share
Price/Earnings Ratio
Payout Ratio
Dividend Yield

Chapter 17. Special Reporting Issues


A.

Separately Reported Components of Income
1. Extraordinary Items
2. Discontinued Operations
3. Income Statement Reporting
4. Other Comprehensive Income
5. Effects of a Change in Accounting Principle
B. Segment Reporting
1. Reporting on Operating Segments
2. Reporting on Foreign Operations and Export Sales
3. Information About Major Customers
4. Products and Services
C. Interim Financial Statements
Chapter 18. Corporate Finance—Valuation
A. Valuation of Securities
1. Valuation of Bonds
a. Mechanics of Bond Value Calculations
b. Determining Market Interest Rates

c. Bonds With Additional Features
2. Valuation of Preferred Stock
a. Nonredeemable Preferred Stock
XXI
b. Redeemable Preferred Stock
c. Rate of Return for Preferred Stock
d. Preferred Stock With Additional Features
3. Valuation of Common Stock
a. Constant Dividends
b. Dividends Growing at a Constant Rate
c. Present Value Analysis
d. Price/Earnings Multiples
e. Determining the Required Rate of Return
B. Cost of Capital
1. Determining a Company’s Cost of Capital
2. Use of Cost of Capital in Capital Budgeting
C. Valuation of a Business
1. Discounted Cash Flow Analysis
a. Estimate the Cash Flows for a Projection Period
b. Terminal Cash Flow
c. Determination of Discount Rate


d. Computation of the Value of the Firm
e. Example
2. Multiples Analysis
3. Asset Values
Chapter 19. International Accounting Issues
A. Accounting by U.S. Businesses Operating in Foreign Countries
1. Foreign Currency Transactions

XXII
2. Translating Foreign Currency Financial Statements
B. Accounting Rules in Other Countries
Appendix A. The Sarbanes–Oxley Act of 2002
1. The Public Company Accounting Oversight Board
2. Registration of Auditing Firms With the PCAOB
3. Regulating Auditing, Quality Control, and Independence Standards
4. Required Independence of Auditing Firms
5. Requirements Related to Audit Committees of Public Companies
6. Responsibilities of Senior Management for Financial Reports
7. Improved Financial Disclosures
Appendix B. Time Value of Money
1. Future Value of $1
2. Present Value of $1
3. Future Value of an Annuity of $1
4. Present Value of an Annuity of $1
5. Irregular Cash Flows
Appendix C. Cross Reference Table Selected Accounting Standards Compilation
Equivalents of Pronouncements Referenced in Prior Editions


1


CHAPTER 1
THE BASIC FINANCIAL STATEMENTS
The main subject matter of this Nutshell is financial accounting. Financial accounting
involves the process of recording transactions in the accounting records of a business and
periodically extracting, sorting, and summarizing the recorded transactions to produce a
set of financial statements. Financial statements are the primary means by which

businesses communicate financial information to various users. When a business issues a
complete set of financial statements, there are four individual statements that are
typically prepared. This chapter will introduce and describe the basic financial statements.
Various items and concepts introduced briefly in this chapter will be discussed in more
detail in later chapters. A general familiarity with the output of the financial accounting
process should assist in understanding the accounting process and the issues that arise in
the preparation of the financial statements.

A. THE BALANCE SHEET
The balance sheet, also called the statement of financial position, sets forth the assets,
liabilities, and owners’ equity (the investment of the owners) of a business as of a
particular point in time (typically, the end of the fiscal Year). The balance sheet is a
2
snapshot as of the date it is issued. A sample balance sheet is shown in Exhibit 1.1. In a
typical balance sheet, the assets are listed on the left hand side. On the right hand side
are listed the liabilities of the business and the owners’ equity accounts.
Exhibit 1.1
Balance Sheet

1. ASSETS


The assets of a business as shown on the balance sheet are of two basic types. One
type of asset is a tangible or intangible property interest or legal right of the business,
something that one normally expects in response to the question, “What do you own?”
Examples of this type of asset are cash (e.g., currency, coins, bank balances),
receivables, whether represented by formal notes or not, inventories, land, buildings and
equipment, patents, trademarks,
3
copyrights, etc. The other type of asset listed on a balance sheet is a “deferred

expense” or “deferred charge.” The concept of deferral will be discussed in Chapter 2. For
now, it is sufficient to note that a deferred expense or deferred charge is a cost incurred
by a business where the business expects to benefit from that cost over a period of time
beyond the current year. An example would be a prepaid subscription to a business
periodical the cost of which will be recognized as an expense over the subscription period.
Some items listed in the assets section of the balance sheet fall in both of the above
categories. A building represents tangible property owned by the business. At the same
time, the cost of the building represents a type of prepaid or deferred expense that will
be recognized and deducted in computing net income over the life of the building through
a process called depreciation accounting (discussed in Chapter 7).
2. LIABILITIES
Liabilities represent the obligations of a business to persons other than the owners of
the business (although owners may also be creditors, particularly in the case of a
corporation). Liabilities may be actual cash obligations payable at some time in the
future, such as accounts payable, notes payable, bonds, and mortgages. These liabilities
may be recognized by formal, written instruments such as
4
promissory notes or they may be based on oral agreements or other informal
understandings.
Liabilities may also be created in several other ways. Some liabilities represent prepaid
revenues (also called deferred income or deferred revenue). This type of liability arises
where money has been collected in advance of rendering a service or delivering goods.
Until that revenue is “earned” and included in the computation of income or loss for the
period, the amount collected is shown as a liability. Accrued liabilities are created when a
business recognizes currently an expense even though there may be no present legal
obligation to pay the item as of the balance sheet date. An example would be the
recognition of the salaries and wages earned by employees through a balance sheet date
that falls in the middle of a payroll period. “Contingent liabilities” are recognized for
possible future obligations of a business where there is no current obligation and it is not
even clear that there ever will be an actual obligation of the business (for example,

recognizing a contingent liability for possible future litigation claims).
3. OWNERS’ EQUITY
Owners’ equity is the residual claim of the owners of the business on its assets after
recognition of the liabilities of the business. Owners’ equity represents the amounts
contributed by the owners to the business, plus the accumulated income of the business
5
since its formation, less any amounts that have been distributed to the owners.
The manner in which owners’ equity is reported in the balance sheet depends on the
legal form of the business (sole proprietorship, partnership, corporation, etc.). For
corporations, the accounts in owners’ equity typically include capital stock, representing
the par or stated value of stock that has been issued, additional paid-in-capital,
representing the amount paid for stock in excess of its par or stated value, and retained
earnings, representing the cumulative or running balance of the net income of the
business less any distributions of dividends to the owners. Certain specialized accounting
procedures may also require recognition of amounts that are treated as additions to, or
subtractions from, owners’ equity.
4. THE BALANCE SHEET EQUATION
There is a fundamental relationship that exists among the three components of the
balance sheet. That relationship is expressed as follows:
Assets = Liabilities + Owners’ Equity
This is a very useful relationship to remember when trying to understand how a
transaction will affect the financial statements. If you know, for example, that a
transaction will cause an asset to increase, then one or more of the following must also
occur to maintain the balance sheet equation:
6
another asset will be decreased, a liability will be increased, or owners’ equity will be
increased. Thus, an increase in cash could result from the disposition of another asset
such as the collection of a receivable, the creation of a liability such as a note payable to

a bank, or an increase in owners’ equity as the result of, for example, an additional
contribution by the owners.
5. BALANCE SHEET FORMAT
Balance sheets are typically prepared in a classified format like the one shown in Exhibit
1.1. In a classified balance sheet, the assets are grouped in two categories. The current
assets are listed first. Current assets are those assets that will generally be converted


into cash or consumed by the business within the coming year. They include cash,
marketable securities, receivables, inventories, and prepaid expenses. The long term or
noncurrent assets are shown next. Long term assets include property, plant, and
equipment, long term intangible assets such as patents, long term investments, and
miscellaneous deferred charges.
In the liabilities section of the balance sheet, current liabilities are generally shown first.
Current liabilities are those liabilities that will be paid within the coming year. 1 They
include accounts payable,
7
short term notes payable, accrued expenses, and the portion of long term debt that will
mature in the next year. The long term liabilities are listed next. Long term liabilities
include long term notes, bonds, and mortgages. Preparation of the classified balance
sheet facilitates financial analysis by segregating the short term or current assets and
liabilities from the long term assets and liabilities. As we will see, a number of frequently
used financial analysis techniques involve computations that segregate the current and
long term assets and liabilities.

B. THE INCOME STATEMENT
The income statement, also called the statement of results of operations, sets forth the
primary components of net income or loss for the year. It is a “flow statement” in that it
reports the income for a period of time, typically one year, ending on the date of the
related balance sheet. The primary components of the income statement are revenues,

expenses, gains, and losses. A sample income statement is shown in Exhibit 1.2.
8
Exhibit 1.2
Income Statement
Revenues
Expenses
Cost of Goods Sold

$125,000

(50,000)
Depreciation Expense
(20,000)
Compensation Expense
(30,000)
Income Tax Expense
(10,000)


Net Income

$ 15,000
1. REVENUES AND GAINS

Revenues include the primary source of earnings of the business, such as the proceeds
from sales of products for manufacturers or merchandising operations and the revenues
received for services rendered by service-type businesses. Also included in revenues are
miscellaneous items such as dividends and interest from investments (of course, interest
and dividends may be the primary source of income for financial companies). Although
usage varies, the term “gains” is typically used to refer to the results of transactions that

occur other than in the ordinary course of business. Gains represent the amounts realized
on sales of assets in excess of the book value of the assets sold. Book value refers to the
amount at which the assets are carried in the financial records. For example, if a machine
having a
9
book value of $30,000 is sold for $75,000, there is a gain of $45,000. These types of
gains may or may not be shown separately from the other revenues of the business
depending on the amount and nature of the gains.
2. EXPENSES AND LOSSES
Expenses are the costs incurred and consumed by the business in generating the
revenues of the business. The principal expenses of most businesses include such items
as cost of goods sold, salaries and wages, depreciation (the cost of fixed assets like
furniture and fixtures treated as consumed in the current period), rent, interest, and
income taxes. The term “losses” usually refers to losses from sales of property or other
events (e.g., litigation or fires) not in the ordinary course of business.
3. FORMAT OF THE INCOME STATEMENT
The revenues and gains for the year, less the expenses and other losses, equals the net
income or loss of the business for the year. Most businesses simply show all the revenues
and gains as a single amount and then subtract all the expenses and losses grouped into
several major categories to compute the net income or loss for the year. This is referred
to as the single step form of income statement. Exhibit 1.2 is a single step income
statement. Some businesses calculate various subtotals before computing the final net
income or loss. Thus, the income statement may first subtract costs of goods
10
sold from sales and report the resulting amount of gross profit or gross margin. Next,
operating expenses are subtracted to produce a subtotal called operating margin, or net
operating margin. Then, other revenues, gains, expenses, and losses are shown and the
final net income or loss number is computed. This is referred to as a multiple step income